Impact of COVID-19 on Frontier Markets
Markets had expected greater economic normalization globally as we headed into the end of 2020, but rising COVID-19 cases in various parts of the world mean the pandemic is likely to persist into the next year. Global policymakers are caught in a balancing act between containing the coronavirus and managing the economic fallout. As investors digest ever-changing signals, financial markets have been volatile.
We expect the current volatile economic and market environment to continue until a vaccine is widely available, with outcomes potentially varying widely by country. Economic recoveries could be shallow and uneven, contrasting with the steep downturns we saw earlier in the year.
Rising sovereign debt levels and higher unemployment are amongst the key challenges that policymakers in frontier markets would have to monitor and address, in our view. Some frontier markets have also underperformed emerging markets this year due to concerns about the physical health care infrastructure in place.
Meanwhile, we believe the outlook for oil-producing economies remains under pressure. Oil prices are still low compared with recent history, and many government budgets remain strained at a time when local economies need fiscal stimulus, thereby constraining governments’ scope and scale of action.
Adapting to the Future
In the MENA region, the United Arab Emirates (UAE) has been a victim of its own success—years of steering the economy towards non-oil sectors such as tourism led to a bigger hit from the outbreak. Nonetheless, we believe that the stock market has more than priced in the potential risks. The UAE has also been proactive in tackling COVID-19, and any health care breakthroughs or normalization in global travel could benefit the economy.
Saudi Arabia’s dependence on oil has resulted in the government leaning on debt markets, the private sector and citizens through various austerity measures, while slowing down its project spending as part of Vision 2030. Value Added Tax (VAT) was increased to 15%, up from 5%, while cost of living allowances were cut for public sector employees.1 Economic weakness and pressure on corporations to employ Saudi nationals have also led to an expat exodus, which exacerbated the slump in demand. More recently however, the Public Investment Fund has signaled a commitment to increase spending in the local economy by US$40 billion annually for 2021 and 2022, while the government lifted the minimum wage for Saudi nationals from US$800 to US$1,070.2
With Egypt’s successful completion of a four-year International Monetary Fund (IMF) program, and the country’s fuel market liberalization, economic reform momentum is largely behind. Monetary policy has successfully contained inflation helped by lower oil prices paving the way for more monetary easing needed at this stage to kickstart the economic recovery.
Kuwait, the largest constituent in the MSCI Frontier Markets Index, was recently upgraded to emerging market status in November—a move that has led to approximately US$2 billion in passive investment. Kuwait’s inclusion should increase the MENA region’s representation to 6% within the MSCI Emerging Markets Index, making it a sizeable component. MSCI had originally scheduled the upgrade for earlier this year in May, but it was delayed due to COVID-19.
In Asia, Vietnam has beaten back a second wave of COVID-19 infections to largely regain investors’ confidence. As the pandemic and US-China tensions drive countries and companies to diversify their supply chains, Vietnam stands out to us as a potential beneficiary. Although the Biden administration will likely approach China with more nuanced diplomacy, the general pivot towards a hard stance on trade with China is unlikely to change. This will mean that the general trend towards supply chain diversification will continue, with Vietnam’s maturing manufacturing sector well-positioned given its moves up the value chain over the years.
Amid shifting winds, our investment focus remains on companies that demonstrate sustainable earnings power, trading at discounts to their intrinsic worth. We particularly favor banks that are well-capitalized, with ample buffers to withstand near-term headwinds, and strong franchises to capture frontier markets’ longer-term growth potential. We also favor companies that have exposure to rising consumption over the long run, reflected in a higher penetration of goods and services or a “premiumization” in demand. For example, some prominent organized retail companies in countries such as Morocco, Peru and the Philippines are likely to become key beneficiaries of a growing population, rising consumption and a steady shift towards this sector
Acceleration of Digital Adoption
The pandemic also resulted in an acceleration of technology and digital adoption across frontier markets. We’ve generally seen higher growth in data and digital payments this year across the African continent, particularly in Kenya, where millions of users and micro, small and medium enterprises, now use a telecoms provider’s platform for managing payments. Elsewhere in Egypt, a fintech player has established itself as a leading digital transformation and e-payment platform, providing 194,000 point-of-sale (POS) machines in the country.
The banking sector has also seen much higher digital adoption from the current client base, on top of a new wave of digital customers. Colombia has seen a huge uptake in banking. For one digital bank, a surge in demand for digital transactions meant customers have more than doubled over the past year, despite a third of customers being previously unbanked.
Long-term Frontier Market Growth Story Shows Potential
Frontier markets continue to exhibit significant economic growth potential. Whilst short-term headwinds exist, we think the long-term story of frontier markets remains intact. The structural opportunity is akin to emerging markets 30 years ago, except that the development curve is likely to be more rapid due to technology availability.
For investors, frontier markets offer regional diversity across the Latin American, Middle Eastern, African, Asian and Eastern European regions. We’ve seen frontier economies push idiosyncratic reforms to support macro development. A highlight here has been Vietnam, which has recently unveiled a set of business reforms aimed at simplifying business procedures, with a focus on digitization. Over the long term, we believe domestic dynamics that are geared toward favorable demographics and under-penetrated sector stories will drive frontier markets.
The asset class remains in its early stages of development compared to larger emerging markets, with lower foreign investor ownership and under-researched market coverage. The prevailing incentive for exposure to frontier markets is really to participate in a regionally diverse asset class with attractive demographics and increased penetration of products all catalyzed by the adoption of technology in ways we previously haven’t seen. We favor companies that could potentially benefit from the secular drivers of favorable demographic and urbanization dynamics.
In contrast to developed markets, most frontier markets have high population growth rates and an expanding working population. In addition, the pace of urbanization in frontier markets, when coupled with lower penetration of basic services, creates potential opportunities to tap into a growing domestic consumer market. We believe these aspects could encourage MENA economies to diversify and become more resilient to commodity cycles.
Our broad research footprint and well-resourced, experienced team allows us to identify what we view as high-quality businesses with sustainable earnings power and structural competitive advantages, trading at a discount to intrinsic value. At the moment, our research and portfolio efforts are centered on identifying balance sheet strength, assessing business model resilience, impairment risk and the path to recovery.
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What Are the Risks?
All investments involve risks, including the possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.
1. Source: General Authority of Zakat & Tax, Saudi Arabia, June 2020.
2. Saudi crown prince says PIF to inject $40 billion annually in economy in 2021, 2022, Reuters, November 13, 2020. The Official Saudi Press Agency, November 2020.